Bank Lobby Widened Volcker Rule, Inciting Foreign Outrage

Last year, U.S. banks including JPMorgan Chase & Co. and Morgan Stanley lobbied the Fed and other regulators to apply the Volcker rule more broadly to companies based outside the U.S., according to four people with knowledge of the discussions who asked not to be identified because the talks were private. Photographer: Jin Lee/Bloomberg

Feb. 23 (Bloomberg) -- U.S. banks pushed regulators to
widen proposed restrictions on trading and hedge-fund ownership
by foreign firms, then encouraged governments around the world
to complain about the rule’s reach.

The two-pronged lobbying strategy resulted in foreign
officials joining U.S. lenders to push back against the Volcker
rule, named after former Federal Reserve Chairman Paul A.
Volcker and incorporated in the 2010 Dodd-Frank Act.

“The criticism of foreign governments on behalf of their
banks is helping U.S. banks fight the rule,” said Anat Admati,
a professor of finance at Stanford University. “It also muddies
the water, shifting the debate away from the main issue, which
is reducing the risks banks impose on the economy.”

The Volcker rule seeks to prevent deposit-taking firms from
making bets with their own capital or owning hedge funds. Last
year, U.S. banks including JPMorgan Chase & Co. and Morgan
Stanley lobbied the Fed and other regulators to apply the
regulation more broadly to companies based outside the U.S.,
according to four people with knowledge of the discussions who
asked not to be identified because the talks were private.

In a December 2010 phone call, a lobbyist for JPMorgan told
Fed officials the Volcker rule would create “a competitive
disadvantage” for U.S. banks, according to a document posted on
the agency’s website. Seven Morgan Stanley executives met with
six Fed staff members last April to express similar concerns,
another document said.

‘Extraordinary’ Reaction

Banks and their lobbyists later sent position papers to the
Washington embassies of foreign governments and met with
officials to warn that sovereign-debt prices would suffer if
U.S. banks are barred under the Volcker rule from buying other
nations’ bonds for their trading accounts, three of the people
said. That led to an outpouring of letters from Canadian,
Japanese and European Union officials, as well as from dozens of
non-U.S. lenders, urging regulators to overhaul the rule.

“The global reaction has been extraordinary,” said Karen
Petrou, managing partner at Federal Financial Analytics, a
Washington-based research firm. “If regulators don’t feel like
they have enough flexibility to satisfy foreign governments’
demands, they could go back to Congress, which would open the
whole rule to revisions.”

298-Page Proposal

In recent months, as regulators sought comments on a 298-page proposal to implement the Volcker rule, the outcry from
banks has swelled. Lobbyists have argued that the plan would
reduce trading in bond markets and increase borrowing costs for
investors and companies. One industry-funded study said the
additional expense just for the corporate bond market could be
as much as $360 billion.

Complaints from foreign nations and banks center on
language in Dodd-Frank exempting U.S. Treasuries from the ban on
proprietary trading because they’re deemed safe, as well as on
the rule’s attempt to control activities outside the U.S.

The exemption for Treasuries didn’t arouse much opposition
until two months ago, after U.S. banks began calling
representatives of foreign governments in Washington, warning
that sovereign-debt prices would suffer if they weren’t allowed
to buy the bonds for their trading accounts, say lobbyists and
regulators familiar with the talks.

Banks based outside the U.S. met with their home-country
regulators and central bankers, briefing them about the dangers
and unfairness of the proposed rules, the people say. Allen &
Overy LLP, a law firm representing a dozen non-U.S. lenders,
including Frankfurt-based Deutsche Bank AG and HSBC Holdings Plc
in London, said its lawyers, accompanied by bank executives,
held meetings with the U.K. Treasury, the European Central Bank,
Canada’s finance ministry and German regulators. The law firm
wouldn’t say which banks participated at the meetings.

Extraterritorial Reach

The Volcker rule’s extraterritorial reach didn’t become
clear until after the Fed, the Federal Deposit Insurance Corp.,
the Office of the Comptroller of the Currency and the Securities
and Exchange Commission published a draft proposal on Oct. 11.
While the Dodd-Frank Act said that U.S. divisions of foreign
banks would have to abide by the restrictions, the plan extended
that to cover the activities of any bank with a connection to
the U.S., even a single branch in one state, according to
lawyers and bank executives.

“If you look at the proposed rule’s preamble, it’s clear
that the U.S. regulators are trying to level the playing field
between their banks and the outsiders,” said Douglas Landy, the
New York-based head of the U.S. financial-services regulatory
practice at Allen & Overy.

Merkley, Levin

Even U.S. Senators Jeff Merkley of Oregon and Carl Levin of
Michigan, who pushed Dodd-Frank’s Volcker rule provision through
Congress, said in a Feb. 13 letter to regulators that the
proposal goes beyond the bill’s original intent by seeking to
prevent non-U.S. banks from owning stakes in private-equity or
hedge funds offered to U.S. citizens.

U.S. banks and their lobbying groups held 21 meetings with
Fed staff from September 2010 to October 2011 to discuss the
Volcker rule, according to the central bank’s website.

The banks started calling on foreign governments and
regulators after the draft proposal was released in October,
with efforts intensifying in December. That culminated in a
flurry of public statements in January and February from high-ranking officials, including Bank of Canada Governor Mark Carney
and EU Financial Services Commissioner Michel Barnier.

Barnier, speaking at a conference in Washington today, said
that it wasn’t “acceptable that U.S. rules have such a wide
effect on other nations.” U.K. and Japanese finance ministers
also weighed in today, saying that without an exemption from the
rule, their governments’ borrowing costs would rise.

Excessive Risk

“At such a vulnerable time in the sovereign debt markets,
it would be the wrong prescription,” U.K.’s George Osborne and
Japan’s Jun Uzumi wrote in a Financial Times opinion article.

The response from foreign governments and banks “shows the
veracity” of the argument U.S. banks have been making since the
Volcker rule was proposed in 2009, said Randy Snook, executive
vice president of the Securities Industry & Financial Markets
Association, which represents the largest U.S. lenders.

“Banks serve a crucial role in government bond markets,
and the regulation would restrict that,” Snook, who’s based in
New York, said in an interview. “It doesn’t respect the market-making role, either, and would hurt these markets seriously.”

Snook declined to say whether banks had lobbied regulators
to extend the Volcker rule’s reach. Spokesmen for Morgan Stanley
and JPMorgan, both based in New York, as well as for the Fed,
the FDIC, the OCC and the SEC declined to comment.

July 20 Deadline

The agencies, which are sifting through more than 300
comments on the proposal, face a July 20 deadline when the
Volcker rule is scheduled to go into effect.

The rule, designed to keep banks from taking excessive
risks, attempts to prevent them from using their own money to
make short-term bets while allowing them to buy and hold
securities temporarily in anticipation of future customer demand
for the trade.

Foreign banks, like their U.S. rivals, will have to prove
that their buying and selling amounts to market-making for
clients, not proprietary trading. They also can’t own more than
a 3 percent stake in any hedge funds or private-equity funds
that do business with U.S. residents, which would rule out most
such investments, bankers and lobbyists say.

Exporting Volcker Rule

The proposed restriction would, for example, prevent a
foreign bank’s London-based trading desk from using the firm’s
capital to bet on any security traded on a U.S. exchange,
according to the Institute of International Bankers, a New York-based lobbying group for overseas lenders with U.S. operations.

That London unit also can’t make any bets involving
investors who are U.S. residents, and the bank’s U.S.-based
brokers can’t take part in transactions, even if both the buyer
and the seller are outside the U.S., the IIB wrote in a Feb. 13
letter to regulators.

“The proposed version basically exports the Volcker rule
to our banks’ home-country operations,” said Richard Coffman,
IIB’s general counsel. “The only way they could avoid the
rule’s reach is by de-banking from the U.S.”

Senators Merkley and Levin backed restrictions on
proprietary trading of sovereign bonds other than U.S.
Treasuries in their letter to regulators. They said dabbling in
such debt could increase risk for U.S. banks. Greece, whose debt
was rated investment grade as recently as 2010, is in the
process of swapping sovereign bonds held by banks and hedge
funds for new ones worth about 70 percent less as the EU tries
to avert a default which could result in even greater losses.

Treasuries Exempted

In their letter, the senators explained that Treasuries
were exempted because they’re safe, don’t pose a foreign-exchange risk for U.S. banks holding them and are used for
liquidity management by the country’s lenders. That isn’t the
case for other sovereign bonds, the senators said.

“For the EU to be treated as safe as U.S. Treasuries is
laughable when they’re restructuring one of their member’s
debt,” said Simon Johnson, an economics professor at the
Massachusetts Institute of Technology. “The lesson we’ve
learned from the EU crisis is that a bank should only consider
as safe the debt backed by its own central bank.”

Volcker has said that barring U.S. banks from trading other
countries’ bonds won’t hurt liquidity in the market for those
securities. The largest banks in Europe, Japan and Canada should
be able to pick up the slack, Volcker, 84, wrote in the
Financial Times on Feb. 14.

Borrowing Costs

Stanford’s Admati said she doubts restrictions on trading
sovereign bonds will raise borrowing costs in any significant
way. A study by Thomas Philippon, a professor of finance at New
York University, showed that increasing liquidity in financial
markets over the past 140 years has made it costlier for
companies to borrow or raise capital. More trading activity
results in a transfer of economic resources to the financial
industry, Philippon wrote in the November paper.

Even if borrowing costs rise when liquidity drops,
complaints from foreign governments are akin to asking for a
subsidy, Admati said.

“Why should the U.S. taxpayer subsidize other governments’
borrowing costs?” Admati said. “When banks insist they must be
the ones providing market-making, they in effect want the U.S.
government to subsidize this activity through its safety net.
This can reduce the borrowing costs of governments only if you
don’t consider the cost to U.S. taxpayers of the safety net.”

Norinchukin Bank

Admati made a similar argument in response to complaints
from banks as far away as Singapore that they will have to abide
by the Volcker rule in their global operations even though they
have only a tiny U.S. presence -- a single branch that helps
corporate clients with trade finance. Those banks can receive
support from the Fed during a financial crisis, she said.

One example: Norinchukin Bank, which pools the resources of
Japanese agricultural and fishing cooperatives. It has only one
branch office in the U.S. and should be exempt from the Volcker
rule, the Tokyo-based lender wrote in a Jan. 25 letter to
regulators. Norinchukin borrowed as much as $22 billion of
emergency funds from the Fed during the financial crisis,
according to data released by the central bank and compiled by
Bloomberg News.

While applying the Volcker rule to foreign banks may help
level the playing field for U.S. firms, it won’t go far enough
in alleviating the burden imposed by new regulations, said
Margaret Tahyar, a New York-based partner at Davis Polk &
Wardwell LLP who represents some of the largest U.S. banks.

“The Volcker rule was already a 90-degree tilt against
U.S. banks in the Dodd-Frank Act, hurting their competitiveness
internationally,” Tahyar said. “Regulators have used some
discretion to lower that disadvantage, but it’s now a 70-degree
tilt -- still pretty steep.”

International Outcry

The international outcry, while it may help U.S. banks make
their case for revising the Volcker rule, won’t undermine its
basic premise, said Kim Olson, a principal at Deloitte & Touche
LLP in New York and a former bank supervisor. A similar global
campaign against capital rules proposed by the Basel Committee
on Banking Supervision in 2010 didn’t deter regulators from
going ahead, she said.

“The big question is whether the merits of the outcry are
solid enough to sway the views of the regulators,” Olson said.

MIT’s Johnson said the lobbying strategy could backfire.

“It’s a miscalculation by the banks,” Johnson said. “The
lobbyists have backed the regulators into a corner. They can’t
give in when all these foreign governments are pressing them. It
would look bad before elections to cave in to foreign demands
when your public wants you to be tough on banks.”

To contact the reporter on this story:
Yalman Onaran in New York at
yonaran@bloomberg.net or @yalman_bn on Twitter